Identifying stocks that are overbought or oversold can be an important part of establishing buy and sell points for stocks, exchange-traded funds, options, forex, or commodities. An oversold market is one that has fallen sharply and expected to bounce higher. On the other hand, an overbought market has risen sharply and is possibly ripe for a decline. Though overbought and oversold charting indicators abound, some are more effective than others.

Relative Strength Index

Two of the most common charting indicators of overbought or oversold conditions are relative strength index (RSI) and stochastics. Developed by J. Welles Wilder Jr. and introduced in the 1978 book New Concepts in Technical Trading Systems, RSI is a measurement of stock price change momentum. RSI is a range-bound oscillator, meaning that its value fluctuates between 0 and 100 depending on the underlying security performance, and is calculated based on prior periods' average gains versus losses.

Key Takeaways

  • Overbought and oversold indicators abound, but RSI and stochastics have stood the test of time.
  • Relative strength index indicates overbought conditions when it moves towards 80 and oversold conditions when it falls below 30.
  • While RSI is computed using average gains and losses, stochastics compares the current price to its range over a given period of time.
  • RSI and stochastics are available on most charting applications, and the default setting is 14 periods, which can be days, weeks, or months.

When RSI indicator approaches 100, it suggests that the average gains increasingly exceed the average losses over the established time frame. The higher the RSI, the stronger and more protracted the bullish trend. A long and aggressive downtrend, on the other hand, results in an RSI that progressively moves toward zero.

RSI levels of 80 or above are considered overbought, as this indicates an especially long run of successively higher prices. An RSI level of 30 or below is considered oversold.

As the number of trading days used in RSI calculation increases, the indicator is considered to be more accurate. Therefore, an RSI computed on a weekly chart is more compelling than one on a daily chart. The standard (default) on most charting applications is 14 periods, which can be measured in minutes, days, weeks, months, or even years.

Stochastics

While relative strength index is calculated based on average gains and losses, stochastics compares the current price level to its range over a given period of time. Stocks tend to close near their highs in an uptrend and near lows in a downtrend. Therefore, price action that moves further from these extremes toward the middle of the range is interpreted as an exhaustion of trend momentum.

A stochastic value of 100 means that prices during the current period closed at the highest price within the established time frame. A stochastic value of 80 or above is considered an indication of an overbought status, with values of 20 or lower indicate oversold status. Like RSI, the default setting for stochastics is 14 periods.

The Bottom Line

Both the relative strength index and stochastics have strengths and weaknesses, and the indicators are best used in combination with other tools designed to establish optimal buy and sell points. Lastly, there are times when a stock, commodity, or market can stay overbought or oversold for a considerable time period before a reversal. Therefore, overbought or oversold signals from RSI or stochastics can sometimes prove premature in strong trending markets.